Lease Basics For Franchisees

Lease Basics For Franchisees

 

Today’s blogpost is about leases. Along with your franchise agreement and perhaps a personal guaranty, your lease is a contractual document that will be with you throughout your journey as a franchisee. In fact, many leases are written to mirror the franchise agreement in initial term and option duration. In today’s post, I’ve put together 5 important clauses that you’ll find in your lease. Make sure you familiarize yourself with these clauses before you execute your lease agreement.

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10 Steps to Opening a Franchise

In this Blog Post, I’m going to share with you the 10 Steps to Opening a Franchise.

Opening up a franchise or any small business can be daunting. There are hundreds of tasks that need to be completed most, within a certain time-frame. Risk increases with ignorance and to that end, its important to understand the big picture, the context of the entire sales and development processes. In this article I’ve outlined a high level overview of the how to open a franchise unit. Its important to note that this post is intended to be a road-map. The specific how-to’s for each task will be covered in a separate posts.

With just a few exceptions, this process can be used to open any small business.

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FAQ: Lease Agreements for Franchise Operations

By: Tiffany Toliver, P.E., LEED AP

I thought I’d take a few minutes and answer some of the frequently asked questions that I get regarding lease agreements for franchised operations.

Q: How long should my initial lease term last?

A: Typically, 10 years; though this answer is not in a vacuum. Consider your ROI, the amount of Tenant Improvement Allowance you are receiving, and finally the length of term in your Franchise Agreement.

Q: Is this a good rent rate?

A: This is also a question that begs several other questions. What is included in that rent number? Are you getting your full work letter for example? Are there rent increases? Are you getting any money for Tenant Improvement Allowance? What is the market rate? What is your ceiling? (based on your projected EBITDA). Having the answers to these questions will help you determine whether your rent rate is appropriate for the trade area and for your operation.

Q: Who should pay the brokers commission?

A: Typically, this is paid in full by the Landlord. However, look for it to be baked into the rent number in some way. Don’t let this concept diminish the role of the broker. A good broker will be able to get you a lower rent rate than if you were to go it alone. They also have their ear to the ground about upcoming projects that aren’t on the market yet.

Q: My building permit is going to cost me in excess of $5K. Can I get the Landlord to pay for this?

A: No. Unless you’ve worked out a ‘turn-key’ deal in the LOI stage.

Q: Do I really need a Real Estate Attorney to review my lease?

A: In my opinion, Yes. Remember that you are signing a contract for a span of 10-years. The money spent on a Real Estate Attorney to review the lease, is money well spent.

Q: Can I just wait and negotiate renewal terms when my lease expires?

A: Technically yes, but you run the risk of the Landlord increasing your rent at a rate that compromises your ROI. Worst case, the Landlord can choose not to renew your lease at all.

Q: Am I bound by an executed Letter of Intent (LOI)?

A: No. An LOI is a ‘Gentlemen’s Agreement’. You cannot be taken to court for backing out of an LOI. You can, however be taken to court for breach of an executed (contractual) Lease Agreement.

Q: I found out the business owner next to me (same center) has a better rent rate. What can I do?

A: Check your lease. Make sure that you are paying the correct rent rates, CAM, Insurance rates, etc. If a meaningful discrepancy in rent rates exists between you and your neighbor, go and talk with the Landlord. Keep an open line of communication and try to come to a compromise.

 

Do you have a question regarding franchising that we can help you answer? Please ask us here and we’ll get back to you!

 

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Can I Walk Away from a Signed Lease?

By Tiffany Toliver

In the development world, the word ‘contingency’ has several meanings. The most common use for the word ‘contingency’ applies to construction budgets. A contractor will set aside a certain percentage of the cost of the entire project towards a contingency category. For example, if the construction cost of the project is estimated to be $1,000,000 then a contractor may set aside 10% of that or $100,000 for unforeseen circumstances.

Another use of the word ‘contingency’ is in regards to the LOI or lease language – that’s what I’ll be expanding upon in this post. A contingency, in this context, is a way for one party to be able to exit the deal if certain agreed-upon criteria are not met. For example, in a typical deal, I’ll always ask for a permit contingency. The language will go something like this:

                “Tenant’s obligations under the lease shall be contingent upon Tenants receiving all applicable building permits, licenses, and other documentation necessary to open and operate Tenant’s Permitted Use.”

A permitting contingency is the most basic of contingencies. It allows the tenant to walk away from a signed lease if he or she is unable to obtain a permit for their specific use. There are other contingencies that could be inserted into an LOI. Contingencies associated with the adequacy of public water or sewer, or permitted-use parking are very common. Usually, the Landlord or developer will counter a Tenant’s contingency with an expiration for which you, the Tenant have to complete your due diligence. They may give you 30 days, for example, to vet out for yourself whether there is water and sewer, or adequate parking. If a contingency expires, it is considered to have been automatically waived. Many times the landlord will hinge the contingency expiration time frame on the day that you execute the LOI. A more advantageous play is to hinge the time frame on the execution of the lease.

Another type of contingency found in the lease language is a financing contingency. If you are able to work this contingency into your lease you’ve won big. In today’s market many Landlords and Developers sneer at a financing contingency as it basically allows you to walk away if you cannot get financed from the bank.

Contingencies can go both ways. In the preceding paragraphs,  you read about the Tenant’s imposition of certain contingencies. Likewise, Landlords and Developers can have their own set of contingencies. For example, a landlord may make the lease contingent upon the review of tenant’s financials or the recapture of the premises from an existing Tenant.

Any and all contingencies should be negotiated in the letter of intent as they are an integral piece of the project timeline and a measure of risk on both the Tenant and the Landlord side. They allow a specified and agreed-upon timeframe to perform necessary due diligence.

 

 

How do Commercial Real Estate Brokers Get Paid?

Brokers are a valuable resource. I often get asked for details about how they get paid. 

Let’s work through an example of how brokers are paid by commission:

A franchisee has agreed to rent a 4,000-sf space at a rental rate of $25 per square foot. The annual total is calculated by multiplying the square footage of the space by the rental rate:

Annual Rent = 4,000 sfx$25.00 psf                                                 

Annual Rent = $100,000

The landlord and the franchisee agree on an initial lease term of 5 years. Multiply the Annual Rent by the number of years in the initial lease term:

Rent Total for the Initial Term = $100,000×5 Years

Rent Total for the Initial Term = $500,000

Brokers’ commissions are usually 6% of the Rent Total for the Initial Term. Multiply the Rent Total for the Initial Term by 6%

Total Brokers Commission = $500,000

Total Brokers Commission = $30,000

The Total Brokers Commission is typically split between the landlord’s broker, and the tenants broker. Each broker gets 3%. Divide the Total Brokers Commission by 2.

Landlords Broker + Tenants Broker Commission = $30,000

Landlords Broker Commission = $15,000

Tenants Broker Commission = $15,000

If either Broker is a part of a brokerage house or partnership, their commission is split even further.

The Power of a Good Broker

Sage advice in site selection: use a commercial broker that lives in the subject market. There are usually two brokers involved in each transaction; a broker representing the Landlord, and a broker representing the Tenant. It is a common mistake for small business owners and franchisees to forego their representation – to just use the Landlords broker. The reasoning is that they believe they can save money on a deal if they go it alone. What they’re not considering is the value that the Tenant-broker brings to the table. Some of the services that brokers provide are trade area intelligence, current market rates, comparable establishments in the immediate area, a buffer in negotiation with the landlord, utilization of a network, experience with different uses, and the ability to get sales data from direct or indirect competition. They will also save you time by turning up multiple opportunities at once, producing heat maps based on your choice demographics, chasing down the answers to your site specific questions, and hosting you on a thorough site tour of the market.

You should spend some time with your broker before they scout any real estate for you. Make sure the two of you are a good personality fit. You’ll be working with them often throughout the lifespan of the deal. Provide them with information on your brand and your target customer. If you, or your Franchisor (if applicable) have certain site criteria, be sure to let your broker know beforehand so that you don’t waste time looking at sites that will not work for you. 

 

 

How Dare You!?

Sometimes development can get heated. Blood pressures rise, adrenaline kicks in, ego comes out. Recently I was privy to one of these exchanges. The topic: a radius restriction.

“How dare you tell me that I can’t open another restaurant!?” Jason said. His face was visibly red. Jason tapped his class ring firmly on the table and waited for the Landlord to respond. He stared at the speakerphone waiting for the Landlords reply. “Jason, your lease with us clearly states there’s a radius restriction.” Alex said in a matter-of-fact tone. “You can’t build another {restaurant} that close to the one in our center.” Alex is the Landlord of a very successful lifestyle center in which Jason has an over-performing, and very popular restaurant. So popular, in fact, Jason has started looking for a site to open a second location. Jason’s pick for location number two is approximately 3.5 miles west of his opened restaurant. “Alex, this new site is over three miles away, there’s no way you can tell me that I can’t open another restaurant three miles away!” Jason said clearly frustrated by what Alex said. “Actually Jason, I can. It’s in your lease with us. Read the lease. There’s a radius restriction in your lease!”  Alex said sternly. The room and the speakerphone fell silent. Jason flipped through his lease to the section Alex had referenced in a previous email. “So you mean to tell me, that I can’t build anything within five miles?” Jason said testing the waters. “Yes”, Alex said. “Five miles, as the crow flies.” Uncomfortable silence ensued. Alex was the first to speak again. “This is tied to your percentage rent clause”.

So why do Landlords impose radius restrictions? Generally radius restrictions and percentage rent clauses show up to the party together. If the Landlord is banking on the collection of percentage rent, and will be sharing in your upside, a radius restriction will protect that collection from your own cannibalization. In dense trade areas, radius restrictions can inhibit your growth strategy. Before you agree to a radius restriction, make sure you map out the extents of the proposed radius so you understand the boundaries. If you’re part of a franchised organization, compare the radius the Landlord is proposing as a radius restriction, to your development boundaries outlined in your franchise agreement.

As with most items in your lease if you knowingly act in conflict, you could be placed in default. If you defy your radius restriction you might be liable for ‘damages’ or for any perceivable loss in the collection of percentage rent.

Related: http://www.franchisefrankness.com/blog/percentage-rent

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Your General Manager Should Read Your Lease

I heard a funny story recently about a General Manager (GM) that obviously had NOT read their proprietors’ lease. Told from the perspective of an absentee owner of a gourmet burger fast casual restaurant, the story went like this:

                “The plane landed at 6:30pm and I drove straight to my restaurant. My GM, James* wasn’t there. The Assistant Manager informed me that he would be right back, that James had been invited to the friends and family event of a new burger joint in the shopping center. I was dumbfounded. How did I not know that there was another burger restaurant opening in the center? I have a water tight exclusive for burgers in this center! I walked down the sidewalk to the endcap of the shopping center and sure enough, the friends and family event for the new burger joint was in full swing. The parking lot was jammed with people and I was just close enough to have the conga line pass right in front of me. James, my GM was number four in the conga line.”

*Name changed to protect the derp

This story made me laugh. Although unfortunate for the business owner, it embodies an important message. Have your GM read your lease. If James had read his proprietors lease, he would have been versed in the exclusive use protecting the owner’s use from a competing burger business. 

There are many other reasons to have your GM or your Director of Operations read your lease(s). Below are just a few:

1)      Maintenance and Utility Repairs – Knowing who is responsible for these items can save you time and money. Think HVAC, roofing, sewer line blockages. If your GM knows who to call immediately, you as an owner will not have the stress of dealing with this yourself.

2)      CAM Services – an example of this is paying for trash removal out of pocket when your lease clearly states this is included in CAM. Your GM should be able to put two and two together.

3)      Renewals timing – your GM can help keep up with your deadlines to renew your lease.

4)      Opportunities – a good example of this is signage. If your lease states that you’re allowed multiple signs and your GM notices a position available on the multitenant sign, pursue it. You don’t get it if you don’t ask.

Have a copy of the lease (redact the rents and other sensitive material if it makes you more comfortable) on site an accessible to your GM and AM.

Empower your GM with information that can positively impact and protect your business. He’ll gain proverbial skin-in-the-game, and you’ll gain an asset.

 

Don’t Pay Rent Until You’re Open for Business

This piece of advice (refer to title) sounds intuitive enough, but I see many business owners get hit with paying rent before their business is open. How does this happen? Delays in lease execution, permitting, construction, or financing can push back opening dates. Overly aggressive project scheduling or flaws in the initial project scheduling can wreak havoc on your commitment dates as well.

So how can you avoid putting out rent money until you’re pulling in revenue? The answer is simple: hinge your rent commencement date (not to be confused with your lease commencement date) on the opening of your unit.

Now, a savvy Landlord will look at this proposal and say, ‘Nice try, Tenant. How do I know that you’re going to open in a timely fashion? You could drag this out infinitely.’ It’s a valid question.

So I insert another clause with a very conservative timeframe. We’ll insert 180 days in this example. The hinge for this clause is pulling a building permit.

The completed Rent Commencement Language reads:

 “Rental Payments shall commence the later of (a) 180 days after Tenants receipt of all permits, or (b) when Tenant opens for business to the public”

Did you notice the ‘later of’ language I inserted at the beginning of the two clauses? How this language is written is that whichever case is the latest to occur will govern. If I open before the 180 day mark (measured from building permit pull) then I’ve essentially given myself some amount of free rent. On the other hand, if I go over the 180 day mark, and open, say at 210 days, then I’m still not paying rent because of the ‘later of’ clause.

Now, a savvy Landlord will counter our ‘later of’ clause with an ‘earlier of’ clause. But even if they do strike your ‘later of’ clause and replace it with the ‘earlier of’, you should be ok unless you’re building something like a hotel. 180 days is a long time to be under construction.